Adapting to the New Reality in Russia

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The current report, kindly provided by Earnst & Young, aims at assisting companies from the consumer products sector to adapt to the new reality in Russia. The report provides an overview of recent economic and sector developments, critical success factors and recommendations.

Critical success factors

Pulling together some of the key themes from the meeting and drawing on our experience of working with consumer products companies in Russia, we believe that in order for companies to “get it right” in Russia, the focus should be on the following:

  • Building strong consumer insights to develop the right offer at the right price. One clear theme is the emergence of a different post-crisis consumer, with a clear focus on value for money and quality. Russian consumers expect more for their rouble across the spectrum of premium to affordable product ranges. As there are still big shifts in consumer behaviors to come, consumer products companies’ success will depend on improving real-time consumer insights and developing the right offer at the right price.
  • Exploiting new market opportunities lower down the consumer pyramid. Although the premium market continues to do well, affordable innovation is the future in a more price-sensitive consumer age. There is a view that Russia is a unique market among developing markets, in that premium and affordable happily coexist. Innovative consumer products companies are adapting and diversifying their portfolio to accommodate “value for money” products or developing cheaper sub-brands to sit alongside their premium offering.
  • Planning talent management for the long term. Western executives are concerned that the quantity of quality resources will deteriorate in the coming years because of the demographics and the erosion of the quality in the educational system. The feed through of the consequences of the 1990s transition will also hit in the next few years but it is difficult to quantify. The question is whether there will be enough skilled individuals from the rural areas or other CIS countries moving to the big cities to compensate for the shortage. In the meantime, attracting, developing and retaining talent has tobe top of the agenda.
  • Improving logistical and operational efficiencies is an ongoing challenge. The cost of doing business in Russia remains high compounded by inefficient supply chain logistics and rising salary levels. However, identifying cost saving opportunities is key to “getting the equation right” at the affordable end of the spectrum. The question remains: are there enough significant efficiencies that can change the cost structure fundamentally in Russia?

This paper provides context and insights on the current environment in Russia and highlights specific points which underpin the strategic imperatives that companies must consider in this market.

Companies have adjusted their expectations

Most of the executives recognized Russia as a strategically important market, with huge upside opportunity. However,they no longer expect double digit growth and profitability as in earlier years. Global HQs are still committed for the longterm but they now have different expectations. Some are starting to view Eastern Europe as a second rate emerging market — with earlier doubts about Russia apparently confirmed by the experience of the last several months.

Losing out to “Chindia” short term

Russia has tended to lose out in terms of HQ attention as aconse quence of uncertainty around its fluctuating performance. In a continuation of the downbeat mood expressed by some at our December meeting, some local leaders commented that they continue to face a challenge in “selling” Russia at an HQ level due to unfavorable comparisons with other emerging markets such as “Chindia” — even though growth expectations have been managed downwards.

The managing director (MD) of one major European food company said: “In Europe, Russia is still a big investment for the company. But it is a harder sell now to global HQ. That said though, the expectations are not as high.”

Longer-term future looks rosier

However, Russia still has several things in its favor. The market is more highly developed, more quality-focused and has offered better profits than its Brazil, Russia, India and China (BRIC)competitors. GDP per capita is four to six times higher than in“Chindia” and sales per capita are 5 to 20 times higher.

One executive from a major US company, which has just completed its first major production investment, explained that in his company Russia still played a major role and could even surpass China strategically because of the quality focus and, for some companies at least, good profitability: “China is a complex market with a high level of competition; Russia is a market with huge growth opportunity — within the next five years Russia will become the top opportunity for the company.”

Notwithstanding the recent difficulties, consumer products companies are optimistic about the future of the Russian market,underpinned by a perception of huge upside potential in the medium to long term. An executive commented that Brazil is their biggest market but that Russia is a very significant growth opportunity, likely to be one of their top two or three markets. He also added: “We are in Russia for the long haul. In some ways, it is now easier to sell to HQ as the expectations are lower. For sometime, Russia was funding the rest of the business so there was pressure for us to deliver results; now, there is a recognition that we need to look after ourselves.”

With companies still committed for the long term in Russia, global HQs need to review when, where and how to invest further in this challenging market as well as their payback expectations.

Economic and business outlook in brief

  • Russia remains a premium market, but there is a huge growth opportunity for affordable innovation. There are very few markets in the world that combine premium and affordable so compellingly.
  • The consumer products sector is expected to come back at the end of 2010 or early 2011.
  • GDP is expected to be 4.5% to 5% this year — the strongest recovery in Central & Eastern Europe, Middle East & Africa(CEEMA). Russia is a “bounce back" market.
  • Disposable income is going up, real wages are going up(4% to 5%) faster than retail sales and unemployment is coming down … but it has not yet translated into consumer spending.
  • The rouble is expected to appreciate marginally against the euro and US dollar over the next year, tracking the global oil price, which should average US$80-88 per barrel next year compared with US$75-83 per barrel this year.
  • Inflation is under control and will probably remain about 6%to 7% in the coming years.
  • Russia is a European BRIC. Although overall growth has weakened, GDP per capita and sales per capita are higher than in “Chindia”. Russia is still seen as a profit market.
  • If China grows at 10%, Russia will grow 5% and the US at 3%.

The expected bounce back has yet to materialize

Executives are uncertain as to when sustainable business recovery will occur. While many agreed that 2010 should be regarded as a year of consolidation, there was some debate over the timing of the recovery, with some hoping for the end of 2010 and others more cautious, citing the early months of 2011.

Assessments of the market vary depending on products and categories. One food sector executive explained that he could see the start of the recovery, and others agreed. Several thought that sustainable recovery could be in place by the end of the year.

Others saw 2010 in more neutral terms as a year of consolidation. One executive explained: “We expected the business to bounce back quicker but it is picking up slowly.” Another one commented: “We keep fighting. We are more stable this year than we were last year. We believe that the consumer will be coming back in 2011.”

As the market is still difficult to predict, a number of executives are being cautious and talk about a 2011 bounce back; they want to manage the expectations of their global HQs as best they can.

Volatility is a big concern

One point that most would agree on was the continuing and inexplicable volatility in trading performance.

Executives across sub-sectors complained they have never seen such fluctuating business results as in the last six to nine months. One executive stated:

There is still no sustainability: one month is good, the next flat, the next very good, the nextterrible … we can’t explain this volatility.”

He also added: “We do not expect the second half of the year to be much better. Companies in the same sub-sector are experiencing the same but a different pattern. We do not understand why.

A senior executive at a global food company related a similar tale:“Some categories not affected too much by the crisis are doing better. Some categories are still not doing well.”

There are two sub-sectors that have fared differently. The beer market has had a tough time, badly impacted earlier this year by hikes in excise duties. Many lobbied the Government over this, but with little success. One industry MD alluded to the last 18 months in Russia as the “most difficult in my career”. His corporate numbers reflected the whole industry closely: business is down by12% and production is down 20%. He had done a lot of work on the cost structure over the last year, closing down two breweries.

The luxury sub-sector has held on. One luxury goods manufacturer was having less difficulty interpreting consumer behavior and predicting numbers, possibly because of their intrinsically closer relationship with the retailer and consumer at the super-premium end of the market.

Market share may be a better performance measure for now

The erratic movements in companies’ top and bottom lines,coupled with the overall slowdown in volume growth, has meant companies may turn increasingly to market share as a better performance metric. Unaffected by factors that dog profitability— like unforeseen regulatory or tax changes, cost to serve, or currency fluctuation — market share is a pure measure of how well companies are performing against global and local competitors.

One executive commented: “We gained market share and hit all our financial targets. Volumes were not great though. We kept prices stable. Categories fell by 15% to 25%. It was a tough year on the top line but we measured success on market share.”

Forecasting difficulties create issues down the line

It is not surprising that many executives across most sub-sectors are now complaining about the quality of marketplace statistics on the ground regarding sales and retail trends. If point of sale information is wrong, late, or both, this presents difficulties in forecasting demand — compounding logistical and supply issues down the line.

Better real time information and consumer insights are increasingly critical to make sense of variable performancepatterns.

Value for money is the new Russian Consumer priority

Russian consumers have redefined “value for money”. Whether at the super-premium or the newer, affordable end of the scale,the story is the same. Quality is non-negotiable and consumers want more for their rouble. The value proposition needs to be obvious and companies need to develop much deeper consumer insight in order to stay ahead of the game.

At the beginning of 2009, companies raised their prices to combat currency devaluation and found that generally consumers accepted most of the price rises. Salaries and incomes were hit through 2009 but started to recover at the beginning of 2010;incomes did even rise a little last year as pensioners, military staff and civil servants were protected by social spending from the government. Unemployment is a concern but the good news here is that this started to stabilize and even decline by summer 2010. Down trading and frequency of purchase have deteriorated and executives are monitoring closely when this will shift. Consumer confidence is fragile and consumers are tending to save more. Consumer confidence will be closely linked to the oil price andconsumption ought to recover steadily as long as oil stays above US$70 per barrel.

As the MD of one company put it: “The crisis has taught the consumer ‘value for money’. We were expecting the market togo up and up. The business fundamentals have not changed. The major change is the consumer — we are looking at a different consumer.”

Another executive committed in the same vein that:

The Russian consumer has clearer idea about value for money — pricing and offer haveto be aligned.”

This means companies are acknowledging that they need to create a perception that it is worth spending the money. If, a sexpected, this change in consumer behavior proves to be deep and long lasting, then companies will need to change and adapt quite radically.

Premium continues to perform, but producers and retailers must work harder

Several executives mentioned that premium-priced products had survived the recession quite well. “Our premium and super premium ranges are growing,” confirmed the CEO of a leading personal care company.

The luxury end of the market in particular has been some what insulated from pricing competition due to a niche offering and limited number of sales channels.

One executive from the luxury goods sector explained: “What we discovered during the recession is that the quality of retail makes a difference. The Russian consumer is still a premium consumer but is more demanding — now, we have to prove in all our interactions with the consumer that we are premium;this includes shopping experience, customer service, etc. We also need to focus on quality.

He added: “The key for our business is global pricing and the exchange rate.” These are causing greater price sensitivity, leading to consumers shopping around, particularly in categories where consumers are more easily able to compare prices: “People will travel to buy goods in cheaper places; now that the rouble has strengthened, it is a challenge for us.”

To ensure a good future for premium products, companies need to offer good quality at what consumers feel is a good price in order to appeal to consumers’ growing sense of the need to justify value, irrespective of price. In an essentially brand loyal culture, “consumers are looking for the connection witht he brand” explained one executive. Companies will need to domore to connect with consumers and articulate a stronger value proposition in order to maintain purchaser loyalty and pricing.

Consumers are more open to affordable offerings but quality still matters

Buy consumer behavior is changing and not everyone in Russia willcontinue to pay premium prices.

Some executives recognized that the dynamics of categories have been linked with pricing. As one executive questioned: “Pricing has always been a lever — is it more sensitive now?” Another also noted that the structure of the market gave consumers new options: “Consumers can find the same product at very different prices depending on where they shop so people are prepared to goto the cheaper retailer — even if the experience and convenience are not as good.”

Although Russian consumers have down traded (but not as much as elsewhere), executives think that they will be among those who start to upgrade first. The Russian consumer is a European consumer in taste, is highly aware of quality and does not look for bargains. Executives agreed that Russian consumers want the Western brands and the lifestyle implications that go with them.

The emerging post-crisis value-led consumer and the consumers in the middle to the lower end of the pyramid still present growth opportunities for most companies.

Companies are adopting different approaches to tap into them. One executive described how they had adapted their offering to cover all price points: “We have a range of tooth brushes from 15 to 120 roubles — the functionality is the same but there are additional features on the most expensive ones.”

The executive also described how the company had adapted its strategy to suit new consumer expectations. “We have developed a large format product which has been seen by the consumer as value for money. People were telling us that it would not work for the Russian market but it did. We were surprised.”

Another executive commented:

The value for money products are not growing yet but there is a huge opportunity there.”

This was echoed by one of the company’s competitors.

Overall, there was a feeling that some categories still have a hugepotential for growth.

Time to review the business model?

Several managers felt that the big question is how to make the whole equation work for affordable products in Russia — with a high cost base, with retailers and consumers exerting downward pressure on prices and radical shifts in consumer behavior, how will a move to greater affordability be made to pay?

The biggest challenge is ‘getting the equation right’ for these affordable products.”

As one executive outlined: “This is a very expensive market to do business in (input costs are very high) and with modern trade developing, it will be very difficult to raise prices. In put prices will be increasing faster than inflation and product prices will be going slower than inflation. How are we going to fund affordable products?” He added: “It is not enough to look at there formulation of your products; the biggest area is efficiencies in your business — where do you find them?”

Many agreed and explained how they had emerged from this recession leaner and fitter but most felt there was still scope to introduce significant cost efficiencies in their business. As the MD of one major company commented: “There is a huge amount of structural inefficiency; for example, in procurement.” He continued by saying that: “You need to relook at your business model, how to make it work; for example, remodelling the coststructure and acquisitions.”

But not all were convinced that this would solve the problem on affordable innovation. One executive felt the cost of distribution was simply much too high and that this was not an issue that could be easily resolved. This problem was exacerbated by poor and inefficient infrastructure.

Most executives are increasingly concerned about this state of infrastructure in Russia. Few believe that there will be any quick and comprehensive improvement on this front. There is a view that companies need to lobby the government more actively about the need to modernize and improve the infrastructure.

Battle for talent is heating up

Executives are clearly concerned that for talented people the market is heating up prematurely — and well ahead of the much-hoped-for up tick in performance. As a consequence, HR directors and senior managers are reviewing their strategies to try and improve the alignment between salary growth and business growth.

One regional director summed up the HR dilemma very neatly:

Salary demands in some cases are growing by 20% to 30% or more, but our sales are only rising at single digits. This is not sustainable. Either salary demands will fall or our business results will have to rise to match them.”

Executives are also monitoring voluntary turnover levels which in the consumer products sector appear to be returning close to pre-crisis levels. This will be a difficult trend to manage because as soon as turnover picks up again, managers can expect to be confronted with yet higher demands.

Questions executives are asking include:

  • Is the hot labor market an indication that we are set fora recovery?
  • How can we think differently/more creatively about retention and reward strategies?
  • Will Russia deliver better leadership because of the crisis?
  • How do we think the unemployment situation will play out —will the downward trend continue?
  • What about migration of labor — how can we understand this better?

One executive felt that Russian staff behaved well during the crisis and “got real" about how things stood. “They want big salaries when things are booming but they understand that we have to cutback in a crisis and they want to keep their jobs.”

Others pointed out that Russian staff had adapted well to the operational challenges of the crisis, learned new business approaches and came up with good ideas, indicating that businesses may emerge from the recession more flexible and better able to compete.

The challenge remains the same as before the crisis. As one executive explained: “There is no more talent in the market place now — the pool is the same.” He added: “It is all about supply and demand.”

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